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Discounted Stock Options: Inherently Evil or Smart Strategy?

October 02, 2016

The media and regulators seem to have a bias against discounted stock options over full value awards that I've never completely understood. I can understand a preference for at-the-money options over discounted options, but why would allowing employees to purchase stock at a discount somehow be worse than giving them the stock at no cost?

A recent article, "The Non-Option: Understanding the Dearth of Discounted Employee Stock Options" authored by Professor David Walker of Boston University, considers this question.

Economically Efficient Compensation

Under ASC 718 (FAS 123(R), as most of you know it), discounted stock options are more efficient than at-the-money options. This is because the discount often isn't a dollar-for-dollar increase in the fair value of the option. For example, assume an option is granted when the market value is $25 per share. If at-the-money, the option has a Black-Scholes value of about $11.50 per share (assuming a 5-year expected life, 50% volatility, no dividends, and an interest rate of 2.5%). If the option is granted with an exercise price of $20 per share, the Black-Scholes value increases to about $13 per share. This is an increase of $1.50 in compensation cost for delivering an additional $5 compensation to employees.

Add in the fact that employees' perception of the value of the option probably increases disproportionately with the discount, just as employees have a disproportionately large perceived value of full value awards, and you're looking at a bargain in terms of compensation.

In fact, as FAS 123(R) went into effect, I was anticipating writing lots of great articles on why companies should be granting discounted stock options. But Section 409A put the kibosh on that. I still secretly hope to come up with a viable design--maybe discounted options with a fixed payout date or that are automatically exercised at vest--but I also secretly hope be interviewed on The Daily Show about my book "Accounting for Stock Compensation" and I think that has just about as a good a chance of happening.

Uncle Sam's Perspective

The article dismisses a number of reasons for the bias against discounted stock options but ultimately points to tax revenue as the most compelling justification for regulators to discourage/prohibit discounted options. For the most part, full value awards are taxed at vest, whereas discounted stock options aren't taxed until exercise. This locks in tax revenue on full value awards that might never be realized on discounted stock options (of course, by deferring taxation, there is the possibility of increased tax revenue, but that's a matter of capital gains vs. ordinary income tax rates--better to lock in ordinary income tax at vest and then collect at a lower tax rate on the additional appreciation than to wait and potentially not collect any tax at all). Walker argues that preventing companies from granting discounted options prevents them from using steeply discounted options to get around the taxation that would normally apply to full value awards.

Synthetic Discounted Options

Walker points out that many companies are in effect granting discounted options by granting a combination of at-the-money options and full value awards. Going back to my earlier example, let's say a company wanted to accomplish the objective of granting 1,000 shares at discount of $5 per share. The company could grant options to purchase 800 shares at a price of $25 per share along with restricted stock units for another 200 shares at no cost. The end result is that the employee is able to acquire 1,000 shares at a price of $20,000 and these shares have an aggregate value of $25,000 when granted, an average discount of $5 per share.

But, the accounting doesn't work out so efficiently. Let's compare:

  • The expense for at-the-money options to purchase 1,000 shares would be $11,500.
  • The expense for options to purchase 1,000 shares at a $5 per share discount would be $13,000. This is an increase in expense of about $1.50 per share to deliver an additional $5 in compensation.
  • The expense for the option/RSU combo would be $14,200 ($11.50 per share for the options to purchase 800 shares plus $25 per share for the 200 restricted stock units). This is an increase of about $2.70 per share to deliver the same additional $5 in compensation; still a good deal but not as good as granting discounted options.

More to Consider

The article has some interesting commentary on discounted options vs. at-the-money options vs. full value awards, NQSOs vs. ISOs, and the efficiency of using a combination of options and awards to achieve the same end as discounted options--definitely worth a read.

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NASPP "To Do" List
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-Barbara

  • Barbara Baksa
    By Barbara Baksa

    Executive Director

    NASPP